When Stalking Unicorns, Proceed with Caution

The technology sector is minting billion dollar companies at a rate not seen since the Internet bubble burst 15 years ago. The latest crop of unicorns—investment speak for startups whose valuation has surpassed $1 billion—includes more than 50 companies. Their sheer numbers have led to a new term, “decacorn” to describe those with private valuations over $10 billion, like Uber, Snapchat, and Airbnb.[1] In some ways, these unicorns are a more mature bunch than their dot.com predecessors.

For the economy and the venture capital industry, the uptick suggests that U.S. innovation and tech leadership has never been stronger. But for investors, the signals are more mixed. On the positive side, some high profile unicorns may be generating revenue and targeting large enough market opportunities to eventually become long-term investments worthy of consideration by investors with the proper risk tolerance. On the negative side, unicorns are staying private for longer, garnering pre-IPO prices that require plenty of fuzzy math to justify an investment. And that could hurt their early performance as public companies. In other words, today’s unicorns are not likely to make speculators a quick trading profit.

Some unicorns are worth less as public companies than they were when private or venture investments were made. This can cause paper profits for employees and other early investors to vanish. Take Square for example. The payment processing startup led by Twitter co-founder Jack Dorsey lowered its initial IPO price in November from an initial range of $11 to $13 to $9 per share. And this came after an earlier private round of financing valued the company at $15.46 per share. Square gained back some of its initial losses when its price “popped” on its first trading day, but unicorns earning IPO prices lower than their peak private valuations is becoming more common.

This could be bad news for investors in growth-oriented mutual funds, as some fund companies are now making private investments in unicorns. Mutual funds must price their portfolios on a daily basis at what is called net asset value. It’s a pretty straightforward process when a fund owns only public companies whose prices are set and readily available on an exchange. But there is no trading market for unicorns, and the way prices are determined is heavily influenced by estimates made by the company founders, early venture capital investors, and later stage institutional investors like fund companies. Many of these later stage investors strike deals to protect their investments and exact penalty payments if the companies don’t go public by a certain date.

Some market watchers suggest the current boom in unicorns signals a new tech bubble. While the venture capital community is always looking for the next Facebook, they are also willing to fund a string of losing investments to increase their chances of hitting a home run. Near-zero interest rates are creating a glut of available capital in Silicon Valley, which is being used to back money-losing unicorns, according to prominent venture capitalist Bill Gurley.[3] And many VCs are ignoring risk in assessing which companies to back, The good news is that their losing bets are unlikely to ever become publicly-traded stocks, which lowers the risks of big losses for Main Street investors. But despite the sky-high valuations that today’s unicorns are earning as private companies, investors would be wise to lower their expectations for similar gains when these companies go public.

Of course, most private companies are not unicorns. While unicorns grab all the headlines, the economy produces thousands of new companies every year, most of which won’t be fought over by venture capitalists and hedge funds, but which still rely on early-stage investors to fund their development. Through its VIA FolioTM platform, Folio Investing offers qualified investors the chance to review and consider private investment offerings. Getting in early on growing private companies doesn’t have to mean chasing unicorns.